Why Sprint's Price War Doesn't Make Sense

By Markets Fool.com

Sprint Corporation ruffled lots of feathers with its strategy to take downAT&T and Verizon Communications , the two telecommunications giants. Sprint, an underdog in the wireless industry behind its two much larger competitors, is going to war to try to win back market share.

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It's undercutting AT&T and Verizon on price through promotions, like offering to cut monthly bills in half for customers who switch over, to try to lure cost-conscious customers away from the two biggest wireless carriers. Shares of AT&T and Verizon have lost ground in the past few weeks based on fears that Sprint's price war will eat into their margins.

Sure enough, AT&T and Verizon followed this up by warning investors that this is indeed happening. Verizon revealed its fourth-quarter margins are going to be hurt by the intense price competition and customer losses taking place. AT&T management stated at an investor conference that customer churn will be higher than usual this quarter.

While this might seem like a savvy strategy to gain traction against its competitors, Sprint's price war makes no sense and this explains why the market isn't convinced about Sprint's strategy. Shares of Sprint are dropping just like AT&T's and Verizon's. The market understands that this tactic can't go on forever, and Sprint management will realize this sooner or later.

A race to the bottom
Companies that engage in a price war with each other do so in order to get the other party, or parties, to blink first. Essentially, Sprint is trying to lure as many customers as it can from AT&T and Verizon with rock-bottom prices. But that can't go on forever.

Sprint may be pleased that the margins of its rivals are going to crumble if they want to retain these customers, but Sprint's margins will erode, as well. Sooner or later, Sprint will have to raise prices on these customers to become profitable. The big problem for Sprint is that it doesn't have much time to wait.

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AT&T and Verizon are massive companies with the financial strength to withstand Sprint's onslaught. AT&T and Verizon hold market capitalizations of $167 billion and $188 billion, respectively. These two companies are likely to see their metrics, like average revenue per user and churn, worsen this quarter; but at some point, customers who move over to Sprint are probably going to be angered if they feel like they've been subject to a "bait-and-switch" tactic.

Sprint's FAQ on the deal says customers will continue to receive the half-price rate plan offer "as long as their account remains in good standing and they remain on the same device."

By comparison, Sprint is a $16 billion company by market value, and it isn't profitable.The company has lost $742 million year to date as of Sept. 30, 2014. It simply doesn't have the luxury of a highly profitable business to go to war with its two bigger and more powerful rivals.

Sprint's network is not as high-quality as AT&T's and Verizon's. The reason why AT&T and Verizon charge higher prices is because they offer better 4G and LTE coverage. And the bigger carriers have much more flexibility in navigating a price war because they are moving away from subsidizing the cost of new phones. Revenue from phone sales will help offset lower revenue per user.

Investors aren't convinced, and you shouldn't be either
It's true that AT&T and Verizon shares are down since Sprint's announcement. Their earnings will suffer. But Sprint's shares are down, too, and are now trading at a 52-week low near $4 per share. The reason is that investors know better.

The market understands that Sprint's strategy is penny-wise and pound-foolish. If Sprint really wants to compete, it needs to make the necessary investments to build its network and improve its product offerings to be on par with AT&T and Verizon.

Sprint has lost 960,000 prepaid and postpaid wireless customers through its first two fiscal quarters. Dragging competitors into a price war that Sprint can only maintain for so long is not a long-term strategy to regain market share.

The article Why Sprint's Price War Doesn't Make Sense originally appeared on Fool.com.

Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Verizon Communications,. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.